Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently initiated coverage of a number of alternative asset managers and found that many of them do possess economic moats. I'm here today with Matt Coffina--he's the editor of Morningstar StockInvestor newsletter--for an overview of the category, a discussion of why they have moats, and a look to see if any of them look attractive today.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's talk about what these alternative asset managers are. How do these businesses operate? How do they make money and how is it different from a traditional asset manager that investors may be more familiar with?

Coffina: Alternative asset manager is really a broad term that applies to any number of firms that manage money primarily for institutions investing in alternative asset classes--things like private equity, hedge funds, real estate, and so on.

The way that they make money is, first, they charge a management fee, which is a percentage of the assets under management. Second, they charge performance fees, and this is typically the largest component of their revenue. They'll get some percentage of the returns earned by the funds that they're managing, usually above some kind of hurdle rate. So, say, after an 8% hurdle rate, the fund company is entitled to 20% of the profits from a given fund. Then lastly, they also earn investment income, so they normally invest some percentage of the capital in their own funds. And as investors in those funds, they're earning investment returns alongside the third-party investors.

So, again, the typical investors in these kinds of products would be institutions, like pension funds or endowments--although companies are increasingly moving into individual retirement products in particular, either launching closed-end funds or even traditional mutual funds, targeting that very large pool of assets that is individual retail investors.

Glaser: But why do these businesses have competitive advantages? What stops other companies from maybe offering similar products? What keeps these firms on top?

Coffina: With traditional asset managers, we usually think of the two main sources of advantage being intangible assets. People don't want to give their money to just anybody; they want to give it to a firm that has a good reputation that they believe is going to manage risk appropriately and is going to earn solid returns over time.

And secondly, switching costs: So, assets tend to be relatively sticky at traditional asset managers. Once people invest in a given fund, they're usually reluctant to move their money around because the payoff of doing so can be so uncertain. Even if your fund underperforms, unless you want to chase performance and just go after the next hot fund (which studies have shown is frequently not going to be the best performing fund in the future), the payoff of switching funds is usually so uncertain that investors don't do it all that often. With alternative asset managers, I think you can make the case that these sources of competitive advantage are even stronger.

So, when it comes to intangible assets, institutions are even more picky about whom they're going to invest their money with and, in particular, a lot of these funds have these lockup periods, which could be 10 years or more when you're not allowed to remove your money from the fund. So, you're going to have to be very certain that you trust whomever you are giving your money to, if you are giving it up for 10 years without being able to withdraw.

These lockup periods also create very high switching costs. In the case of traditional asset managers, you are relying on investor inertia to let the money stay put. With alternative asset managers, they are frequently explicitly restricting withdrawals during this, say, 10-year investment period, which means that those funds are locked in and they are going to be earning some kind of return--at least the management fees but hopefully the performance fees as well over time for at least that 10-year period.

I think what we've seen over time is that more and more of the assets that are devoted to alternatives are flowing to the top firms, companies like Blackstone, KKR, Carlyle, Apollo Global Management, and Oaktree. And then another secular trend has been the shift in the total percentage of assets that is going to alternatives. We are seeing signs now that some pension funds are reconsidering that positioning, but for a long time--especially since the financial crisis--the allocation of alternatives has been steadily climbing, as people have wanted to protect against market declines or try to make up for funding gaps by earning higher returns over time. That perspective has started to change a little bit now with such a strong bull market.

Some of these alternatives have actually lagged the S&P 500. But that's just sort of a pendulum, I think, that goes back and forth over time. Over a multi-decade period, the broader trend has been an increase in allocations to alternatives, mostly driven by their very strong returns over time. So, a lot of private equity funds in particular--at least from the best companies--have delivered very exceptional returns over long periods of time.

Glaser: But what's the risk here then? If the stock market were to decline or alternatives start to underperform, could these companies get into trouble quickly? What sort of risk do investors need to keep in mind?

Coffina: I think that's definitely the challenge with these companies. First of all, there's very little persistence to the revenue. So, again, a very large percentage of the revenue is coming from performance fees, and those performance fees can decline 50% or more from one year to the next, depending on how the underlying funds are performing. And the performance of those funds, of course, is going to be very closely linked to market conditions.

I happen to think that we are in a very favorable period right now for alternative funds. Just think about, really, where we are. A few years ago in 2008-09, a lot of these funds had a lot of money to invest, and those investments are now being realized five or so years later. They made some very attractive investments at very depressed asset prices five years ago, and now we have a situation with very low interest rates, very high equity markets, and favorable credit conditions where credit spreads are as low as they have been in years. So, private equity funds--as well as the other alternative asset managers--are able to realize some pretty healthy gains on a lot of the investments that they made five years ago and some very healthy performance fees along with that.

If you saw, for example, a significant increase in interest rates, increased regulatory pressure on fee levels and the amount of leverage that these companies can take on when making investments, decline in equity prices which make it harder to exit a lot of investments either through initial public offerings or through mergers and acquisitions--another ready exit strategy for a lot of these companies is to sell their portfolio companies to other companies. And right now, there is a lot of interest in mergers and acquisitions. So, we're in a nearly ideal environment, I would say, for alternative asset managers right now. And it's really anyone's guess as to how long that is going to last. But I will tell you that at some point it's not going to be such a favorable environment, and it's going to be very difficult for these companies. They could see perhaps very substantial earnings declines even from one year to the next.

Ideally, I think it's probably a better time to invest in these companies when the markets are down and people are really pessimistic--a 2008-09 kind of time period. But that said, our analyst looking at the long-run cash flow potential of a lot of these businesses still finds them to be undervalued. And a couple of names in particular that stand out would be Oaktree and Apollo Global Management--also Blackstone for its wide economic moat. That's the only one we think has a wide moat. And for investors I think that can be very patient and have very strong stomachs, some of these names could be attractive. But for my purposes, I'm mostly going to be keeping an eye on them for that next downturn. If stocks sell off in a big way and conditions aren't so favorable in earnings and distributable cash flow is collapsing, that's the time that these companies could be very interesting.

Glaser: Are there any other considerations that investors should have? I know that some of these are partnerships. What kinds of tax implications are there here?

Coffina: That's a very important point. All of the alternative asset managers that we cover are organized as partnerships, which give them tax implications similar to a Master Limited Partnership like a pipeline company--in that they have pass-through taxation. So, they are going to issue K-1 [tax forms] every year that can complicate an investor's personal tax filing. It also means that they may not be appropriate for tax-deferred accounts such as IRAs. So, certainly before investing in any of these companies, you should consult a tax professional and understand what the tax implications are.

Glaser: Matt, thanks so much for your take on this today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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